1/19/2006 @ 8:29AM

Japan's Selloff Just A Speed Bump

As the Japanese stock market is rocked and closed down for the first time in more than 50 years, investors need to assess why the market has hit a speed bump and what comes next.

First, during the markets 42% rise in 2005, foreign investors were doing all the investing. The Tokyo Stock Exchange reported recently that through November, overseas investors purchased a net $81 billion in Japanese shares. This is a record, and more than they purchased at the top in 1999.

A recent
Merrill Lynch
survey also indicated that 62% of U.S. fund managers were overweight on Japan. This is saying a lot, since Japan represents about 25% of the benchmark MSCI EAFE Index and 50% of Asian stock-market capitalization. Therefore, what looks like a market weighting to many looks to me like too big a bet on the Japanese market. Even in our Asian opportunity portfolio we have never gone beyond a 25% weighting for Japan.

Second, Japanese institutional investors have been net sellers of Japanese equities, while individual investors have only nibbled at the market. A recent Wall Street Journal article reports that in October, individual net purchases were only $1 billion. All signs point to the Japanese being traders, not long-term investors with full faith in Japans economic recovery. One wonders whether the recent meltdown will make them more gun-shy and trading-oriented.

Third, an overreliance by foreign investors on the
iShares Japan Index
that tracks the Nikkei 225 puts too much pressure on the vehicle as foreign investors head for the exits to lock in profits.

Fourth, the Japanese are classic momentum investors, pushing values way beyond any reasonable limit. Forget any fundamental analysis: If it goes up, it attracts capital, whether it is the Japanese, U.S. or Indian market.

In Japan, there is reality (honne) and appearance (tatemae). Most of the news accounts I read emphasize all the positive trends and downplay the risks. Perhaps the Japanese are too gun-shy after many false hopes, but perhaps they see the reality clearer than we do.

Japan is a massive restructuring play, and there are a lot of good signs: Banks are in much better shape, real estate prices are turning positive for the first time in 14 years, 2% economic growth is welcome after many years of stagnation, exports are strong and the successful Junichiro Koizumi-led reform efforts may indicate substantial change is on the way.

But still, the Japanese may be thinking twice because they know the reality. Many firms will do well, but the high-flying growth of the past is gone. Exports to China are strong, but both China and South Korea are right on Japan’s heels in terms of technology. High budget deficits together with a rapidly aging population means tax hikes. Japans bureaucrats are resisting reforms tooth and nail, and many of the old ways will be incredibly hard to change.

The market may very well bounce back as foreign and Japanese investors keep faith in the Japan restructuring story. My bet is that they will be more conservative and also look for domestic-oriented companies where there is still good value and less downside risk.

My advice is to focus on the Japanese investors and follow their lead.

Carlton Delfeld is head of the global advisory firm Chartwell Partners and editor of Chartwell Advisor. He served as a director on the executive board of the Asian Development Bank during the administration of President George H.W. Bush, and he is the author of The New Global Investor. Click here for more analysis from Delfeld or to subscribe to Chartwell Advisor.